It’s tempting to think that venture capitalists are taking punts on particular technologies in the hope that the few investments that reach the big time adequately compensate for the many that wither on the vine.  It’s a narrative that paints a picture of investors backing perhaps a single startup in an industry, but research from Wharton highlights how VCs increasingly hedge their bets across a number of startups, and what’s more, this practice actually improves the efficiency of innovation in that sector.  This is because they can see which startups are performing badly and encourage them to shift their energy and focus into new areas.

The findings emerged from an analysis of the pharmaceutical industry, with over 1,000 Phase I drug projects analyzed from nearly 500 startups.  The projects were collectively backed by 764 different VC firms.  Innovation efficiency was measured in terms of the number of drugs that ultimately achieved approval by the FDA, scaled by the total VC funding provided to all startups in that category.

Supporting innovation

The results show that so-called “common ownership”, where VCs invest in a number of projects in the same space, was positively associated with a strong return on funding.  The authors believe this is largely because this approach helped startups avoid excess duplication of effort and therefore produce more approved drugs per dollar of investment.

This has obvious benefits for society, although by limiting the number of firms working on a single solution it does also place significant pressure on that one project to actually succeed, which as we know, is far from certain in the inherently uncertain world of innovation.

Nonetheless, the authors believe that common ownership does allow investors to encourage startups to move their efforts when they’re lagging behind.

“If the firms instead have different owners, they fail to internalize the negative spillovers they impose on each other,” they explain. “The lagging project is therefore likely to continue, even if it is socially suboptimal.”

It’s a practice that is surprisingly common in the pharma industry, with 39% of startups sharing a VC with a close competitor.

“If you’re the founder of a pharma startup, it’s important to know whether your VC investors are also invested in your competitors,” the authors say. “According to our results, common ownership can influence whether your funding gets cut off in the future and whether your drug projects make it through clinical trials.”